Discretionary Trust Questions

[SYD]

Hello,

I am considering using a discretionary trust for our next IP.

I have some questions I would like to ask the forum. I have been grappling with some issues regarding to the practicalities of running a discretionary trust and would appreciate any real life examples.

I’m thinking of having a vanilla DT with a corporate trustee and potentially having a company as a beneficiary as well as the family members. A property I am looking at is CF+ and is suitable for the DT as the sole investment.

My questions relate to distributions of income, and how to retain cash in the trust.

1 Let’s say the trust is set up and buys a $1,000,000 property that in the first year returns $100,000 in rent and the only expense is $80,000 interest on an IO loan. The trust’s income for the year is $20,000 and this needs to be distributed to the beneficiaries. Does the $20,000 have to be physically paid out or are there ways for this money to remain in the trust?

2 Let’s say that instead of an IO loan, the trust had a P&I loan and repaid $10,000 of principal (on top of the $80,000 interest). The income is still $20,000 and needs to be distributed but in this scenario there is $10,000 less cash available. How do people get around this?

3 Let’s say the property does well and is sold after a couple of years for $2,000,000 (capital gain = $1,000,000). After repaying the loan there is $1,000,000 in the bank account. This needs to be distributed to the beneficiaries. Let’s say there are 3 beneficiaries; husband, the wife and a corporate beneficiary. Is it unwise to distribute any capital gains to the corporate beneficiary as it wont be entitled to the 50% discount? What are the strategies of distributing the capital gain? Is it possible to keep the cash in the trust for the next investment?

Thanks,
SYD

 

[alexlee]

Obviously check with your accountant. The following are accurate as far as I know, but I'm not taking legal responsibility for it.

A property I am looking at is CF+ and is suitable for the DT as the sole investment.

Are you aware of the difference between positive taxable income and cf+? You can have a tax loss but positive cashflow for an individually owned property, but a trust can't distribute tax losses.

1 Let’s say the trust is set up and buys a $1,000,000 property that in the first year returns $100,000 in rent and the only expense is $80,000 interest on an IO loan. The trust’s income for the year is $20,000 and this needs to be distributed to the beneficiaries. Does the $20,000 have to be physically paid out or are there ways for this money to remain in the trust?

The distribution can be recorded as just a loan from the beneficiary. The cash can remain in the trust.

2 Let’s say that instead of an IO loan, the trust had a P&I loan and repaid $10,000 of principal (on top of the $80,000 interest). The income is still $20,000 and needs to be distributed but in this scenario there is $10,000 less cash available. How do people get around this?

The distribution is recorded as a loan payable to the beneficiary. There is often a difference between taxable income and cash income, such as depreciation, franking credits, etc.

3 Let’s say the property does well and is sold after a couple of years for $2,000,000 (capital gain = $1,000,000). After repaying the loan there is $1,000,000 in the bank account. This needs to be distributed to the beneficiaries. Let’s say there are 3 beneficiaries; husband, the wife and a corporate beneficiary. Is it unwise to distribute any capital gains to the corporate beneficiary as it wont be entitled to the 50% discount? What are the strategies of distributing the capital gain? Is it possible to keep the cash in the trust for the next investment?

The cg is unlikely to be 1m, since it'll probably have to be adjusted for depreciation, buying costs, etc, but yes, since companies don't get the cg discount, the individual's tax rate with the cg discount will be lower than 30% at even the highest current marginal rate.

Strategy for distributing capital gain would still be to the person/entity with the lowest tax rate, but in this case a company would always have a higher tax rate than the individual.

Yes, the cash can be kept in the trust, again as a loan payable to the beneficiary.

 

[SYD]

Yes I am aware of positive taxable income and CF. I was just trying to keep the example simple.

Regarding loans from the beneficiaries: Is interest payable on these loans? What happens if one of the beneficiaries demands repayment of their loan? Are these unnecessary concerns in practice.

Thanks.
SYD

 

[taxguy]

Strictly speaking they wouldn't be loans, they're "unpaid present entitlements" and should be accounted for as such, particularly to ensure that any distributions to the corporate beneficiary aren't caught by Division 7A, which deems a "loan" to be an unfranked dividend to the trust (which would result in the amount of the loan being taxable in the trust).

Be careful, the tax office has released a draft taxation ruling basically saying that if a company doesn't demand repayment of a UPE, it turns into a loan which would get caught under Division 7A anyway. The opinion in the tax community is that this is basically wrong, but you should keep in contact with your accountant about this.

Interest is not payable on UPEs. You could pay interest if you wanted to, but you probably wouldn't.

They must, however, be repayable on demand. If not, then the trust gets taxed on the income at 46.5% (beneficiaries aren't subject to tax on the distributions if they're not "presently entitled" to the income - that is, they must be able to call for the payment).

Using a trust as a property investment vehicle makes things very complex. See your accountant and work out whether it's useful, given the tax risks and costs involved.

 

[dan c]

1. No it doesn't have to be physically paid out. It would be recorded in the accounts of the trust as an unpaid present entitlement. In practice most trusts have unpaid present entitlements to beneficiaries, as they use this money, or some of it, as working capital.

3. Generally capital gains would be distributed to individuals, as they are entitled to the 50% reduction and companies are not. So individuals would be paying max tax of 23.25%, compared to 30% for the company.

Also, be aware that using a company beneficiary MAY be more problematic in the future, due to the release of ATO draft ruling TR 2009/D8. This would treat the unpaid present entitlement from the trust to the company as an unpaid loan, or worse, an unfranked dividend. It's only at draft stage at the moment, and the accounting bodies are complaining about it, so it will be interesting to see what happens.